Cryptocurrencies, the Fed and Inflation

The crypto market, which enjoyed immense success at the start of the coronavirus pandemic, has precipitously fallen from its highest mark. Since November 2021, there has been a sell-off from the emerging asset class. This has halved the global market to $1.5 trillion from $3 trillion as of February 17th, 2022.

Although cryptocurrencies have been an extraordinarily volatile asset class, their fortunes have often seemed immune to the influence of traditional market forces. Over the last years, the enormous price gains that cryptos have been gaining have been stimulated by a heady combination of hype, speculation and network effects.

So, what is the cause of the most recent downturn? According to financial experts, the latest sell-off could have more to do with the traditional economic factors as compared to what has moved crypto prices historically.

A mix of interest rate hikes, high inflation and a sell-off in the regular stock market looks like the main reason behind the latest declines in the value of cryptocurrencies. Ironically, this undercuts one of the central arguments that cryptocurrency advocates often use – cryptos act as a hedge against any inflation and fiat currency policies from the central bank, such as the US dollar.

CryptoLists here go through a few details about what might have forced the cryptocurrency industry to go down lately. Keep reading to find out more about cryptocurrency trading..

Reasons Why the Cryptocurrency Market is Down

A few years ago, it was believed that cryptocurrencies do not move with the fluctuations in the traditional financial market. However, recent trends are indicated that both cryptocurrencies and traditional financial markets are strongly intertwined.

The continuing cryptocurrency sell-off seems very related to the high inflates rates in the US. In December 2021, US inflation reached 7%, which is its highest annual rate of inflation since 1982. Unlike in the stagflation crisis in the 1970s, the US is not experiencing any stagnant economic growth. The demand is attaining all-time highs; however, the global supply chains are failing to keep up with the demand.

To curb the tide of price fluctuations, the Federal Reserve is intending in 2022 to introduce three interest rate hikes; but it has grappled with this decision for months. If the key problem to the bottlenecks in the supply chain, then the hikes in interest rates alone cannot solve the problem of inflation.

The doubts regarding this inflationary period – and what the Fed can do to handle the situation – have reflected already in the traditional financial markets. The Nasdaq 100 and the S&P 500 both fell 16% and 10% respectively from their annual highs in December 2021.

With that said, it’s safe to say that the crypto industry is now part and parcel of the wide sell-offs of risky assets. This can be attributed to the new signals from the Fed of beginning to increase interest rates to reverse this inflationary period.

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Will the Crypto Industry Rise or fall with the Market?

One of the primary appeals for cryptocurrencies has been their invulnerability to inflation. This has marketed them as a safe haven where traders and investors can avoid the inflation associated with central bank currencies.

JPMorgan Chase released a report in October 2021 where they said that institutional investors were putting their money into Bitcoin as the better hedge from price fluctuations as compared to gold. The rationale used here is that the supply of the majority of cryptos is fixed. As with Bitcoin, only 21 million tokens are in circulation currently. After every four years, the number of Bitcoin tokens is cut in half.

Thus, the scarcity of the token will largely influence the value of the token as compared to the traditional economic factors. In turn, it will insulate the cryptocurrency from inflationary pressure which comes from more supply.

Valuation of crypto – more use cases than inflation?

Most probably, the value of cryptos is mainly influenced by their use cases – network effects (as with developers such as Ethereum), payments (as with Bitcoin) and old-fashioned hype. Therefore, as more institutional traders and investors buy-in, the cryptocurrency markets have become more interrelated with the traditional financial markets.

Although this institutional interest accelerates the crypto prices stratospherically, it also ties them to traditional assets which increases their volatility. For instance, back in 2019 when cryptos were first emerging into the mainstream, many large financial institutions began to accumulate cryptocurrency reserves. A survey from Fidelity Investments in 2021 indicated that 52% of institutional investors had Bitcoin or other cryptos.

The problem is, when traders sell, they don’t just sell a single asset class. They might sell their assets to cover for some losses in another class. This is the main reason why cryptocurrencies are correlated with the traditional financial markets.

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